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Read the Fine Print Before You Sell Your Bankruptcy Claim

Bankruptcy Law Update Christopher Combest

Creditors may often view bankruptcy claims as liabilities, but some investment firms treat them as assets, for which they are willing to pay cash. However, purchase documents for those claims often come with significant financial risk for the creditor-seller, even after a claim sale. The Second Circuit Court of Appeals, in Longacre Master Fund, Ltd. v. ATS Automation Tooling Systems, Inc., demonstrated how expensive that risk might be, permitting claims purchaser Longacre to go to trial and seek almost $820,000 from seller ATS for breach of the purchase contract.

ATS Automation Tooling (ATS) must have been relieved to have sold its $2.14 million claim against Delphi Automotive Systems, LLC (Delphi) to Longacre Master Fund, Ltd. (Longacre). Unfortunately, the transaction became more complicated, creating headaches for both ATS and Longacre: Although Delphi initially planned to pay claims like ATS's in full, Delphi ultimately proposed a distribution of just under 40% of the face value of such claims. Longacre, in the meantime, had paid $1.9 million for ATS's claim - 89% of face value.

When can a claim seller actually keep the buyer's payment?

Longacre had imposed a condition on its payment to ATS - one typical of the claims-trading industry - that ATS refund the purchase price, with 10% interest from the effective date of the transaction to the final allowance of the claim, if the claim was objected to or otherwise challenged for any reason, regardless of whether the objection was ultimately sustained. If the claim subsequently survived the objection, Longacre would then pay the money back again. Also a typical component of such purchase agreements was ATS's representation that it was not subject to any preference lawsuit by Delphi.

A preference lawsuit seeks to recover money paid by a debtor to a creditor within 90 days of the debtor's bankruptcy filing, so any creditor who receives such a payment may be exposed to such a lawsuit. Longacre and other parties that purchase claim settlements care about such risk because a debtor may refuse to pay an otherwise-valid claim until the creditor pays back any preferential transfers it received.

This situation applied to the ATS-Longacre matter because ATS had received $17.3 million from Delphi during the 90 days preceding Delphi's bankruptcy filing. Accordingly, Delphi filed a preference complaint against ATS to recover that amount, and it filed a pleading in which it "reserved the right" to object to ATS's claim in the event the preference action went forward, which it eventually did. Longacre demanded a refund; ATS refused.  So, Longacre sued for the $1.9 million purchase price plus interest, citing the refund provisions. In response, ATS argued that Delphi had not truly objected to the claim but, rather, had merely reserved its right to object at a later date. ATS also denied that it had any knowledge of a preference lawsuit from Delphi in 2006, the date of the completed purchase transaction with Longacre; therefore, ATS contended, the refund obligation had never been triggered.

While the Longacre lawsuit was pending, Delphi withdrew its objection to the ATS claim.  Therefore, even if ATS had refunded Longacre's $1.9 million purchase price when the objection was filed, Longacre would have had to return that payment to ATS when the objection was withdrawn. However, Longacre still sought payment from ATS of almost $820,000 of interest accrued on that $1.9 million during the four years from the closing of the sale (December 2006) through final allowance of the claim (March 2011). The lower court, denying Longacre a trial, ruled for ATS as a matter of law, holding, among other things, that Delphi's reservation of rights was not an "objection" within the meaning of the purchase contract and that ATS had no preference liability to Delphi in December 2006, when the purchase was closed; therefore, the court held, ATS never owed Longacre a refund or interest.

The Second Circuit Disagrees

That was not the end of the story, however. The Second Circuit vacated that ruling, holding that the language of the purchase agreement was much broader than ATS asserted. The agreement gave Longacre a right to a refund whenever the possibility of a claim objection - even a meritless one - was raised by Delphi. Delphi's reservation of the right to prosecute an objection represented a possible impairment of the claim that could trigger the refund right, absent other defenses that ATS might raise. Moreover, because ATS had received $17.3 million from Delphi during the 90 days pre-bankruptcy, a preference lawsuit was always possible, and ATS may therefore have breached its representation. The appellate court sent the case back for a trial, to permit Longacre to establish ATS's liability on the facts of the case and to allow ATS to defend. In short, the Second Circuit ruled that the contract means what it says, and Longacre may sue ATS for the $820,000 of interest.

Takeaways

The contract provisions at issue in the Longacre case are not the only potentially expensive ones for sellers in such transactions. For example, purchase contracts can (i) require sellers to pay any damages incurred by the purchaser as a result of the seller's breach, (ii) demand assurances about aspects of the claim that may be out of the seller's control and (iii) require the seller to pay the buyer's attorneys' fees in connection with any claim objection.

Quarles bankruptcy attorneys are familiar with the rights and obligations of both sellers and purchasers of claims and have successfully negotiated purchase agreements that moderate risks for the seller while preserving the essential bargain for the purchaser. Consulting with an insolvency professional can help you evaluate the risks and benefits of cashing out of a bankruptcy case.

For more information, please contact author Christopher Combest at (312) 715-5091 / christopher.combest@quarles.com, your local Quarles & Brady LLP attorney or one of the following Commercial Bankruptcy, Restructuring and Creditors' Rights practitioners: John Harris at (602) 229-5406 / john.harris@quarles.com (Phoenix), Faye B. Feinstein at (312) 715-5069 / faye.feinstein@quarles.com (Chicago), Roy Prange at (608) 283-2485 / roy.prange@quarles.com (Madison), Susan Boswell at (520) 770-8713 / susan.boswell@quarles.com (Tucson) or Philip V. Martino at (813) 387-0263 / philip.martino@quarles.com (Tampa).